Options trading can generate big profits, or big losses, through financial leverage. The leverage allows investors to protect their portfolio while giving speculators an opportunity to amplify profits from price moves. This dynamic generates tantalizing opportunities that constantly abound in the option market. However, would-be options traders need a clear understanding of how options pricing works, the risks involved, and the best practices for choosing the best platform on which to trade. We’ve compiled the basics every option trader should know, and have structured this guide for trading options to answer the questions most novice option traders have.
Options allow traders to make a leveraged bet on what might happen next with a security’s price. Each standard option controls 100 shares and has a designated strike price and expiration date.
Option contract holders aren’t required to exercise their rights to buy or sell shares. They can let the option expire worthless (and forfeit what they spent on it), or they can sell the option contract to another trader for whatever amount that trader is willing to pay. If the contract’s value increases, they can make a profit without ever exercising the option or having to own the stock. However, if the value decreases, losses result.
Call options let you purchase the security at its strike price, which can be done any time before expiration. At expiration, the broker will automatically exercise the option if the price of the underlying shares exceeds the value of the strike price. Put options give you the right to sell the security at the strike price any time before expiration. The broker will exercise the option at expiration, but only if the price of the underlying shares is below the value of the strike price before the contract expires.
The value of call options will generally increase as the underlying security goes up in price, while the value of put options will increase as the security falls in price. But there are certain basic elements that go into option pricing that every trader should be aware of, and the price of the underlying shares is only one of them.
Call option buyers can exercise their right to purchase shares and establish a long position in the stock. Put option buyers exercise their right to sell shares and establish a short position in the stock. But there is a difference in the moment when a contract can be exercised based on the style of the option contract.
American-style options can be exercised at any time leading up to the close of the expiration date, but European-style options can only be exercised on the date of expiration. However, both option styles can be bought or sold up until expiration. Most exchange-traded securities are American-style options, while most index-based options are European-style options
When an option contract reaches expiration, the terms of the contract are settled, meaning both parties in the contract receive what they are due. Call options for stocks or other exchange-traded securities are settled by assigning shares of the underlying security to the call option buyer and assigning the call option seller the obligation to provide those shares. If the seller holds those shares already, they are removed from the seller’s account and placed in the buyer’s account. If the seller does not have the shares in their account, the buyer is still given shares, but the seller is assigned a short position in the security.
For options on indexes, the contract is settled to cash. Option buyers who find their contracts in the money at expiration will receive a cash equivalent of the intrinsic value of the option, while the option sellers are required to pay that cash from their account. Options that expire out of the money are worthless and no cash changes hands at expiration
Once you're prepared to explore the world of options trading, you will need to research the brokers with which you can open an account. After you have selected a broker to use and filled out the account application (this is usually done online and is fairly quick), then you can request options trading approval.
Step 2: Register an account. Broker requirements for approving options trading in your account can vary widely. Some brokers may have a tiered level of option trading approval (lower tiers include buying and selling options; higher tiers include spread trading, index trading, and selling uncovered options).
Some brokers may ask you to complete a questionnaire or take an online course to demonstrate your knowledge of options trading. All such requirements are stipulated by the broker simply to manage their risk. Consequently, the higher your net worth or the larger your account, the less strict a broker is likely to be about such requirements
Step 3: Fund your account. Once your application is processed and you are approved for options trading, you will want to fund your account with more than the minimum required amount, and review and accept the language of the options agreement. If you plan to trade options on margin, you'll need to meet your brokerage firm's margin requirements. This can include meeting ongoing minimum balance requirements and promptly addressing margin calls. Once these are complete, your account will be capable of trading options.
Step 4: Research option strategies. Successful option trading is more complex than stock trading because it requires factoring critical elements, such as volatility and time decay. Options trading strategies range from simple one-leg strategies, like simply buying puts or calls, to complex multi-leg strategies like iron condors. All strategies have varying sensitivity to the passage of time, fluctuations in price, and changes in implied volatility, and it is critical to understand what trade-offs each strategy includes.
Before you can start trading options, you need to open an account with a brokerage firm. To do this, you'll need to provide personal information such as:
Name
Address
Social Security number
Employment status
Job title
These are provided for account ownership and standard banking purposes.
The broker will also ask you to provide additional information regarding the following key items:
1.Financial status
2.Liquid assets
3.Trading experience
4.Risk tolerance
5.Option trading knowledge
This information is used to assess the risk of having you as a customer. It helps the broker reduce the risk that you might make a trading mistake that could somehow spill over from your account and impact their business
